State and Trends of the Carbon Market 2009

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The World Bank

State and Trends of the Carbon Market 2009

Washington, D.C. [ May 2009

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S ^{TATE AND} T ^{RENDS OF}

THE C ^ARBON M ^ARKET 2009

Karan Capoor

Sustainable Development Operations, World Bank

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Philippe Ambrosi

Climate Change Team, World Bank

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∗ The findings and opinions expressed in this report are the sole responsibility of the authors. They do not necessarily reflect the views of the World Bank or of any of the participants in the carbon funds or facilities managed by the World Bank.

This report is not intended to form the basis of an investment decision.

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CKNOWLEDGMENTS

E WOULD LIKE TO acknowledge the input and insight provided by Evolution Markets Inc. We are grateful to our many colleagues in the carbon market for their cooperation and assistance in preparing this report. Special thanks are due to Anita Gordon, Alexandre Kossoy, Sidney Nakahodo, Sara Pais, Monali Ranade and Johannes Woelcke, Richard Zechter.

We wish to also extend our thanks to Edwin Aalders, Imtiaz Ahmad, Ellysar Baroudy, Noreen Beg, Abhishek Bhaskar, Martina Bosi, Marcos Castro, Michelle Caulfield, Charles Cormier, Karen Degouve, Jane Ebinger, Emmanuel Fages, Anita Gordon, Isabel Hagbrink, Kate Hamilton, Olivia Hartridge, Johannes Heister, Takashi Hongo, Nathalie Johnson, Anya Kareena, Abyd Karmali, Keith Kozloff, Nuno Lacasta, Aditi Maheshwari, Marco Monroy, Lucy Mortimer, Ken Newcombe, Shahyar Niakan, John O'Brien, Alexandrina Platonova-Oquab, Neeraj Prasad, Venkata Ramana Putti, Rama Chandra Reddy, Kirtan Sahoo, Laurent Segalen, Chandra Shekhar Sinha, Marc Stuart, Nicholas Tatrallyay, Nuyi Tao, Bruce Usher, Jari Väyrynen, Xueman Wang as well as numerous other colleagues choosing to remain unnamed from various firms and governments around the world as well as Regional Operations and Carbon Finance Unit staff at the World Bank.

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XECUTIVE

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UMMARY

YEAR OF SIGNIFICANT GLOBAL CHANGES

Over the past year, the global economy has cooled significantly, a far cry from the boom just a year ago in various countries and across markets. At the same time, the scientific community communicated the heightened urgency of taking action on climate change. Policymakers at national, regional and international levels have put forward proposals to respond to the climate challenge. The most concrete of these is the adopted EU Climate & Energy package (20% below 1990 levels by 2020), which guarantees a level of carbon market continuity beyond 2012. The EU package, along with proposals from the U.S. and Australia, tries to address the key issues of ambition, flexibility, scope and competitiveness. Taken together, the proposals tabled by the major industrialized countries do not match the aggregate level of Annex I ambition called for by the Intergovernmental Panel on Climate Change, or IPCC (25-40% reductions below 1990).¹ Setting targets in line with the science will send the right market signal to stimulate greater cooperation with developing countries to scale up mitigation.

Table 1: Carbon Market at a Glance, Volumes & Values in 2007-08

2007 2008

Volume Value Volume Value

(MtCO2e) (MUS$) (MtCO2e) (MUS$)

Project-based Transactions

Primary CDM 552 7,433 389 6,519

JI 41 499 20 294

Voluntary market 43 263 54 397

Sub total 636 8,195 463 7,210

Secondary CDM

Sub total 240 5,451 1,072 26,277

Allowances Markets

EU ETS 2,060 49,065 3,093 91,910

New South Wales 25 224 31 183

Chicago Climate

Exchange 23 72 69 309

RGGI na na 65 246

AAUs na na 18 211

Sub total 2,108 49,361 3,276 92,859

TOTAL 2,984 63,007 4,811 126,345

Overall Market Grows

The overall carbon market continued to grow in 2008, reaching a total value transacted of about US$126 billion (€86 billion) at the end of the year, double its 2007 value (Table 1). Approximately US$92 billion (€63 billion) of this overall value is accounted for by transactions of allowances and

1 See Box 13.7 in Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change

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derivatives under the EU Emissions Trading Scheme (EU ETS) for compliance, risk management, arbitrage, raising cash and profit-taking purposes. The second largest segment of the carbon market was the secondary market for Certified Emission Reductions (sCERs), which is a financial market with spot, futures and options transactions in excess of US$26 billion, or €18 billion, representing a five-fold increase in both value and volume over 2007. These trades do not directly give rise to emission reductions unlike transactions in the primary market.

Cashing in on Carbon During the Credit Crunch

Like other markets, prices in the European carbon markets started to decline late last summer from their highs of July 2008, on the back of lower oil and energy prices and a deteriorating economic outlook. Demand for carbon allowances fell sharply in late 2008 and early 2009 as the recession reduced economic output, resulting in much lower emissions than had been expected. A large European Union Allowances (EUAs) sell-off started in September 2008, as companies realized that the allowances they had received at no charge were valuable assets, particularly in the midst of the financial credit crunch. The EUA sell-off, mostly on the spot market, was followed by a discernible increase in trading of EUA options (more calls than puts, on average), showing the intent of some installations to hedge any anticipated 2008-12 compliance exposure.

EUA Decline Squeezes Primary CER Markets

The price spread between EUAs and secondary CERs, which had remained in the range of €9-11 until July 2008, started to narrow until it completely disappeared in February 2009. The primary CER (i.e., CERs purchased directly from entities in developing countries or pCERs) market was initially more resilient, until the spread between sCER prices and pCER prices narrowed so much that buyers had moved away from the primary market. Market data in this time-frame confirm a strong preference for option and futures contracts for guaranteed assets in the EUA and sCER markets and away from pCER and spot markets for issued CERs. In recent days, carbon prices across the board have recovered considerably and spreads have begun to widen again, despite the expectation of some analysts that the 2008-12 market appears to be net long overall.

Project-based Market Faces Challenges

Confirmed transactions for pCERs declined nearly 30% to around 389 million CERs from 552 million CERs in 2007 (Table 1). The corresponding value of these pCER transactions declined 12% to around US$6.5 billion in 2008 (€4.5 billion), compared to US$7.4 billion reported in 2007 (€5.4 billion). Confirmed transactions for Joint Implementation (JI) also declined 41% in value to about US$294 million (€201 million) for about 20 MtCO2e transacted in 2008. The supply of Clean Development Mechanism (CDM) and JI in 2008 and early 2009 continued to be constrained by regulatory delays in registration and issuance and the financial crisis made project financing extremely difficult to obtain.

To further complicate matters for CDM demand, 2008 and early 2009 also saw several pioneering transactions of about 90 million Assigned Amount Units (AAUs) with related Green Investment Schemes (GIS) at various stages of elaboration. The economic blues also affected the voluntary market, which saw transactions of 54 MtCO₂e in 2008 (up 26% over 2007) for a value of US$397 million, or €271 million (up 51%), but still fell short of the exponential growth of previous years.

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Potential CDM Demand Remains but is Largely Unrealized

On the supply side, analysts revised downward their expectations for real (risk-adjusted) CDM supply to between 1,300 and 1,700 MtCO₂e due to a combination of regulatory delays, the difficulty in obtaining financing for projects in a challenging global financial environment, and the renegotiation or cancellation of some carbon contracts. CDM had nominally contracted much of the maximum allowable limits in the 2008-12 phase of the EU ETS, although not yet the nominal revised higher EU ETS Phase III limits.

On the demand side, some potential demand for Kyoto Mechanism units remains despite the economic slowdown. In Japan, for example, the economic tsunami has brought the level of effort required to meet Kyoto targets within reach with the help of CDM and, in particular, recent AAU/GIS transactions. Several countries, such as Austria, Belgium, Denmark, Finland, Italy, Norway, Portugal, Spain and Switzerland, are also continuing with existing plans for carbon purchases in 2009.

European utilities express concern about post-2012 CDM contracting due to continuing lack of clarity about EU rules post-2012.

In this uncertain climate, one could expect that credits from projects in Least Developed Countries (LDCs) could have an edge for post-2012 contracting, if the projects could obtain underlying financing and emerge from the CDM regulatory process more quickly.

Project Aggregators get Unexpected Relief

Lower CER prices unexpectedly brought some good news for project aggregation companies as well, which had previously sold forward more CERs for guaranteed delivery than had been issued by the CDM Executive Board. Some were able to either reschedule or cancel their deliveries by mutual consent of their secondary buyers. Companies that had previously hedged their portfolios by buying put options on the secondary markets at high prices, chose to exercise these options. Some even booked significant first-time profits by buying and delivering lower priced spot CERs. Many companies were shifting their focus – and their staffing needs – away from the relentless origination of new ERPAs toward maintaining and maximizing “production” from their existing project portfolios.

The U.S. is Back at the Table…and the World Pays Attention

The most significant change in the policy landscape over the past years is the re-emergence of the United States in the climate change debate. The Waxman-Markey (“W-M”) bill has reached the full House of Representatives. At the time of this writing, it calls for reductions in GHG emissions of 17% below 2005 levels by 2020.

IGEM, a model used by the U.S. Environmental Protection Agency (US EPA) to analyze the W-M bill, relies on the latest U.S. Energy Information Agency (EIA) scenario,² and projects that U.S. GHG emissions will likely remain below 2005 levels until about 2020, even in the absence of new climate policy. It anticipates that the projected level of effort by covered U.S. entities gradually increases to 3,291 MtCO₂e over the 2012-20 period, for an annualized estimated gap-to-target of 366 MtCO₂e.

However, this estimate is uncertain and the gap-to-effort may change substantially depending on the timing and pace of resumed economic growth in the U.S.

2 Annual Energy Outlook (2009 revised) by Energy Information Agency, U.S. Department of Energy. Based on an EPA analysis of the Waxman-Markey draft using the ADAGE model, CO2 emissions from energy use are projected to represent an average of 80% of overall US GHG emissions and 96% of the GHG emissions of entities covered under the scope of the original Waxman-Markey draft of March 31, 2009.

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New Direction Likely for Project-based Emission Reduction Activities

The W-M bill, which does not automatically accept all CDM-certified credits, however provides generous allowable limits of two billion tons annually from domestic and international offsets, and international allowance trading. The EU has indicated that if there is a satisfactory international agreement, then it will adopt a stronger target of 30% below 1990 levels by 2020, creating an additional demand of about 300 MtCO₂e per year over 2013-2020. The demand from the U.S. and EU combined will create an opportunity for developing countries to scale-up their supply of emission reduction credits.

This, in turn, will require that the CDM evolve to meet this challenge. In its best year, it has so far seen no more than 430 projects registered with expected emission reductions of about 80 million CERs per year. Proposals contained in the EU package and in draft U.S. anticipate a CDM very different from the one we know today. The European Commission (EC) has proposed that the project-based mechanism of today be limited to LDCs in the future, and that major emerging economies be able to transact credits generated from additional reductions beyond an agreed benchmark for sectors e.g., steel, cement and power. Market experience has shown that stimulating offset supply will need a sufficient price signal, a wide range of eligible offset types, sufficient lead time for project development and an efficient offset approval process. Expanding the scope and scale of offsets and credits (to include, for example, international mitigation activities in agriculture, such as soil-based sequestration and through programmatic approaches) will be important to expand the participation of developing countries and should, in turn, encourage more ambitious targets from industrialized countries.

Cycle-proof Regulation

There have been calls for market intervention following recent volatility in the EU-ETS market. The general approach of establishing medium-term targets with flexibility across compliance periods, as proposed in the draft U.S. bill and integral to the design of the EU-ETS, provides a built-in cushion to accommodate the ebb and flow of economic cycles. This should provide further comfort to policymakers that more ambitious reductions can be accommodated with such a design. There may be additional ways to smooth the effect of inevitable economic cycles on emissions markets, without distorting their proper functioning, and this year’s report discusses some practical approaches for policymakers to consider (Section 2.4).

Complexity and the Quest for Clarity

It is good news for the global environment that the EU, U.S. and others are seriously engaged in climate policy. Even a seasoned observer might struggle with the complexity of the numerous proposed emissions trading policies and packages. This calls for greater simplicity, comparability of targets and transparency of underlying assumptions (including for provisions to preserve competitiveness). In addition to the CDM, there are now over a dozen carbon certification standards that compete with each other for market acceptance. Competition and choice is good for the market;

however consolidation of the most attractive features across regimes and standards could help reduce complexity and enable closer linkage across markets.

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II ALLOWANCE-BASED MARKETS

NUMBER OF national and sub-regional carbon market initiatives in Annex I Parties, including the EU and the U.S., are either already underway, seriously under discussion, or actively being revised. If designed compatibly with science-based mitigation targets, they will have the potential to create significant value and opportunities for harvesting low cost mitigation opportunities through the market by addressing key issues of ambition, flexibility, scope and competitiveness.

Table 2: Annual Volumes and Values of Transactions on the Main Allowances Markets (2007-08)

2007 2008

Volume Value Volume Value

(MtCO2e) (MUS$) (MtCO2e) (MUS$)

EU ETS 2,060 49,065 3,093 91,910

New South Wales 25 224 31 183

Chicago Climate

Exchange 23 72 69 309

RGGI Na na 65 246

AAUs Na na 18 211

TOTAL 2,108 49,361 3,276 92,859

2.1 EUETS

High Growth, Liquid and Volatile

EU ETS continued to dominate the global carbon market in 2008, with transactions valued at US$92 billion (€63 billion), which represented an 87% year-on-year growth over 2007 (Table 2).

Over three billion EUA spot, future and option contracts traded for a variety of purposes, including compliance, risk management, arbitrage and profit-taking.

A highly volatile market, spot EUA prices (currently trading in the band of €10-15) declined nearly 75% over a period of 7-8 months, from a record-high of €28.73 in July 2008 down to as low as €7.96 on February 12, 2009.³ Similar declines occurred in prices of futures contracts for EUAs and secondary CERs (Figure 1).⁴ Trading activity picked up dramatically in the second half of 2008, peaking in early 2009, during a particularly strong EUA sell-off by industrials looking for liquidity in a tighter credit environment. They sold mostly on the spot market – which saw a dramatic increase in activity and broke daily and monthly records for traded volumes during that period. This is reflected in market data which shows that spot transactions accounted for only 1% of all transactions in the first half of 2008, rising to 7% in the third quarter and 19% in the fourth quarter (and accounting for 36%

of all transactions in December 2008 alone).

The options market, used as a tool to hedge against price volatility and volume risk, also continued to grow briskly. To illustrate, options volume on the European Climate Exchange (ECX) grew five-fold to 240 MtCO₂e between 2007 and 2008. Based on observed growth rate during the period January to April 2009, it could be on track to more than double in 2009. In late 2008, the options market for

3 Data from Bluenext.

4 After a volatile year, any number of factors could explain the most recent run-up in EUA prices. As in the oil markets or stock markets, some analysts believe that they could be indicators of market perceptions of the resumption of economic growth. Prices of carbon allowances typically show sensitivity to the supply-demand gap in the system, which, in turn, are influenced by the ambition of targets, allocation of allowances, rate of economic growth, weather conditions, fuel price differentials, level of abatement, system flexibility and the availability and cost of offsets.

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EUAs started transacting not just for Dec-09 compliance but also for Dec-10. By January 2009, there was significant option interest across all vintages, including Dec-11 and Dec-12 vintages as traders began to hedge their potential volume risk arising out of any over-selling in the earlier months.

2.1.1 Carbon Hit by Recession

Cashing in on Carbon during the Carbon Crunch

Economic slowdown in Europe and elsewhere led to lower demand for housing and cement, automobiles and steel, and so on. As demand and commodity prices collapsed, cement and steel companies substantially cut back their production and power consumption. Emissions were lower as was their need to purchase any carbon because they were granted free allocations prior to Phase II when the economy was healthy, global demand for commodities was strong and their actual emissions were higher.

Figure 1: Carbon Prices Respond to the Recession

EUA sCER

0 5 10 15 20 25

Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09

pCER

(offtake) (€ per tCO₂e)

Source: Spot EUA and sCER (closing price): Bluenext; primary CER (average price for categories b and c): IDEA Carbon.

Companies holding substantially more free allowances than they needed for compliance (typically industrials such as steel and cement sectors) chose to sell EUAs on the market to raise cheap cash in a difficult credit environment. Trading activity spiked sharply with record-breaking daily and monthly volumes on the spot market, in particular. Higher supply and lower demand for allowances brought substantially lower prices for EUAs. This inclination to sell the EUAs in their possession was greatly boosted by the fact that companies did not have to pay to obtain these allowances in the first place, but rather they were granted them for free.

The EUA sell-off was further amplified by the overlap in holding allowances between the time 2008 allowances were to be surrendered (April 30 2009) and the time that 2009 allowances were issued (February 2009). This enabled operators to sell 2008 allowances, knowing that they could use the 2009 allowances to cover any shortfall for 2008. Many operators sold their 2008 allowances for cash, and hedged their expected future exposure by purchasing later maturity options and futures at an

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attractive price, netting them, in effect, a discount-priced loan at a time when obtaining credit was expensive, if not impossible.

EMISSIONS DECLINED BUT ETS WAS NET SHORT IN 2008

On April 1, 2009, the European Commission posted verified 2008 emissions data for EU ETS installations.

Analysts had anticipated an overall short EU ETS in 2008, and the 2008 preliminary verified emissions data showed indeed that despite the economic downturn, ETS was still net short in 2008. As a result, the release of verified emissions data did not cause significant market movement.

In emissions trading, policymakers establish the emissions limits and regulated entities are to comply by remaining within those limits. Regulators are to periodically release emissions data which can help analysts to determine the quantity of emissions-to-cap balance in the market. When disclosed on April 1, 2009, 2008 emissions of ETS installations amounted to 1,981 MtCO2e or just over 90% of 2007 verified emissions. Unfortunately, the released data is not directly comparable to 2007 verified emissions since all installations had not reported their emissions and the scope of the ETS had changed between Phase II and Phase III.

Analysis is further complicated by the fact that the exact cap (amount of allowances in circulation) for 2008 is not known with accuracy, despite efforts by the EC to collect information from some Member States on final allocations made on the installation-level. Some Member States also did not clearly communicate their intentions regarding auctioning. Finally, little is known about how much of the New Entrants Reserve (NER) has been released to new entrants. This underscores the critical importance of having full, transparent and comparable information and reporting about emissions-related data.⁵

To illustrate, on April 8, 2009, the EU indicated that 2008 verified emissions data (including Liechtenstein and Norway) amounted to 2,031 MtCO2e for the 10,085 installations which reported. Comparing 2007 and 2008 emissions for installations that reported for both years, it appears that year-on-year emissions from these sources dropped on average by 4.6% in 2008.⁶

The above number for overall allocation does not, however, include 50 million EUAs that were auctioned in Germany and the UK, nor Norway’s plans to auction about 7 MtCO2e per year. Assuming that all planned auctioning had occurred, and extrapolating missing 2008 data for installations from their 2007 data, analysts may conclude that the 2008 shortfall is really the difference between 2,127 MtCO2e (2008 emissions) and 2,083 MtCO2e (Phase II average cap), or a shortfall of 40-50 MtCO2e. If Member States had not auctioned all they intended to, or if they had drawn less from their NERs than planned, then the actual shortfall would be greater. Without having access to this information on a timely basis, the market can only guess at the overall shortfall or length of the market.

Investors (i.e., not compliance players) also off-loaded their long positions to raise cash in a falling market. These actions combined resulted in bringing a large supply of EUAs to the market with insufficient matching demand, bringing prices down dramatically.⁷ Although there was more buying and higher prices again at the end of April 2009, this could be attributed to the need of some compliance buyers to close their positions for 2008 compliance.

5 Data were still missing when the installation-level compliance data for 2008 were unveiled on May 15, 2009.

6 Analyst New Carbon Finance credits carbon regulation in Europe for contributing 30% of this emissions drop, while recession and power diversification accounted for 40% and 30% respectively.

7 At this time, the strong correlation between EUAs’ price and oil price, that could have been observed through 2008 (in its June heydays as in its slump through H2’08), temporarily broke in early 2009.

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2.1.2 What to Expect for the Remainder of Phase II?

A reasonable question is what to expect of the remainder of the Phase II market. The shortfall of EU ETS for Phase II is clearly expected to be much smaller than one year ago. Several analysts even project that the 2008-12 market is probably net long (Table 3), even though power producers in Germany and UK will probably still be short. Much of this shortfall can largely be addressed through surrendering of CERs and Emission Reduction Units (ERUs) and from cheap abatement measures.

Banking of carbon assets from Phase II to Phase III (which is supposed to have tougher targets with an increased level of auctioning and benchmarking) could encourage market participants to buy

“excess” or “surplus” EUAs and bank those for Phase III. The bankability of CERs (and ERUs) to Phase III also gives an incentive to acquire and bank those assets, if there are expectations for a truly tight Phase III market, and if the EU rules clarify eligibility of project types and countries of origin.

Barring a swift economic recovery in 2009, the prospects of high carbon prices over the next year or two are relatively low. It is the view of the authors that the continuing economic slump in Europe and elsewhere will likely result in more length in the market over the coming year and consequently lower EUA prices. This may present an opportunity for those with a longer-term outlook beyond 2012 in the ETS and with a view to supplying linked schemes in the U.S. and Australia.

Table 3: A View on Analysts’ Expectations for EU ETS Phase II&III

Projections for Phase II Projections for Phase III (20% target)

position

(+ short/-long) CDM/JI banking sCER price

EUA price

position

(+short/-long) CDM/JI sCER price

EUA price (MtCO2e) (MtCO2e) (MtCO2e) (€/tCO2e) (€/tCO2e) (MtCO2e) (MtCO2e) (€/tCO2e) (€/tCO2e)

Barclays -67 400 467 10-17 11-20 3,596 1,900 30 40

Cheuvreux 439 893 454 12-23 10-21 20 30-35

Orbeo 345 875 530 13.7-18 11.5-20 3,855 880 23-38

Source: Barclays Capital. Monthly Carbon Standard, May 2009; Cheuvreux. Carbon Research, March 2009;

Société Générale. Carbon Specials, May 2009.

2.1.3 20-20-20 by 2020: the Climate and Energy Package is Adopted

The European Parliament adopted the Climate and Energy Package on December 17, 2008, making carbon market continuity beyond 2012 more concrete. Strengthening and expanding the EU ETS is central to the EU’s strategy to and beyond 2020, and this is a core element of the package, whose main objectives are:⁸

- to reduce overall GHG emissions to 20% below 1990 levels by 2020 (possibly scaling up to 30% in the event of a satisfactory international agreement being reached);

- to increase the share of renewable energy sources to 20% by 2020; and,

8 The package also includes the following additional components:

- binding, but differentiated, targets for Member States on renewable energy to achieve the EU target of 20% share of renewable energy in 2020, including provision for Member States to count renewable energy imported from new facilities in non-Member States (e.g. Concentrated Solar Power in North Africa);

- a new tradable “Guarantee of Origin” (GoO) label that would allow energy customers to purchase electricity with information about which renewable source it was generated from, which technology, the dates and places of production, and in the case of hydroelectric installations, indicate the capacity;

- binding, undifferentiated 10% target for renewables in transport (assorted with criteria for biofuel sustainability);

- regulatory framework to enable the deployment of carbon capture and storage (CCS) – with public support for demonstration projects using part of the revenues from the sale or auction of EUAs (including a dedicated lot of 300 million EUAs available up until 2015 – considered to address the needs of up to 12 projects);

- binding targets for emissions from fleets of new cars to an average of 120 gCO2/km and a longer-term goal of 95 gCO₂/km by 2020, along with complementary measures such as the fuel quality directive.

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- to improve energy efficiency by 20% by 2020.

Spanning less than one year, discussions and negotiations on the proposed package focused around issues reflecting the differentiation of Member States on issues such as:

- auctioning of allowances and its implications for the power sector in each Member State;

- concerns regarding competitiveness and the potential risk of carbon leakage;

- differentiation of mitigation commitments across Member States; and, - transition or “compensation” schemes.

The EU package was finally adopted with compromises primarily concerning provisions for auctioning while the emissions targets were confirmed. Next steps include technical implementation of the agreement, and, in particular developing rules for auctioning, benchmarking for free allocation, identification of sectors subject to leakage, and defining the scope of offsets use.

EU ETS Phase III Ambition

The EU target of 20% below 1990 levels corresponds to a 14% reduction below 2005 levels by 2020.

Taken together with EC actions since 1990, this is to date the most ambitious target put forward in the run-up to Copenhagen. However the EC package falls short of IPCC findings that call for 25-40%

reductions by 2020 by industrialized countries in order to stabilize atmospheric concentrations at 450 ppm. Proposals by other industrialized countries are even less ambitious over the same time horizon since they tend to consider stabilization of emissions at 1990 levels, or less stringent objectives, before bringing down reductions in the later years.

INDICATIVE SCIENCE-BASED TARGET RANGES

It is very helpful for policymakers to provide the market with an early indication of likely future carbon constraints. This need for advance indication of future constraints should be informed by, and should accommodate, the latest scientific information on climate change and technology options for mitigation.

Setting Phase III allocations a decade prior to 2020 and Phase IV allocations potentially even more years in advance, could make it difficult to adjust future commitments based on the latest science.

One approach to balancing these concerns (and consistent with the Australian ETS proposal that is currently undergoing revisions) could be to set a longer-term signal of the range of possible carbon constraints. Policymakers could announce future expected reductions in a range, with the higher end of the range reflecting the best scientific information at that time. In this way, the market would not be surprised if policymakers reacted to the latest science by adjusting the cap downward no more than a year or two before the start of the next applicable compliance phase.

Gradually Deeper Emissions Cuts by 2020

Gradually requiring tighter caps and providing an indicative cap that goes out to 2020 increases the planning horizon for investment in long-lived capital stock. A single EU-wide cap will be implemented, which is a sign of increased harmonization for Phase III.⁹ For sectors included in the ETS, the cap on emissions is expected to decrease at 1.74% per year rate with the 2010 allocation as a reference. Based on Phase II coverage and allocation (2,080 million EUAs per year, on average), this would correspond to an EU-wide allocation of 1,974 million EUAs by 2013, decreasing to 1,720 million EUAs by 2020. The final annual emissions cap for Phase III will be announced by September 30, 2010 (accounting for new entrants in already covered sectors and new sectors, such as chemical

9 Other elements of increased harmonization include: a sole EU-wide New Entrants Reserve (5% of the entire amount of allowances), centralized allocation rules for installations and for auctioning, as well as a proposed single EU registry.

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and aluminum industries, bringing new GHGs – nitrous oxide (N2O) and perfluorocarbons (PFCs) - under the scheme), a full 10 years ahead of 2020, the final year of Phase III.

To achieve the 20% reduction goal, sectors already covered by the EU ETS assume a larger share of the effort, with required reductions of 21% below 2005 levels,¹⁰ while other sectors (transport, building, agriculture and waste, which account for about 60% of EU GHG emissions) take on a target of 10% below 2005 levels. This target is differentiated among Member States (with criteria reflecting, among other things, GDP per capita) leading to national targets ranging from -20% to 20%

below 2005 levels. This differentiation is one of the so-called “compensation” mechanisms across Member States in the package, together with provisions concerning auctioning of EUAs to power sector installations and distribution of allowances among Member States.

Auctioning: At least 50% of EUAs to be Auctioned by 2013

Auctioning is one area where major revisions have been made to the January 2008 European Commission proposal, resulting in a more gradual phasing-in than had previously been expected.¹¹ As a whole, it is estimated that about half of allowances will be auctioned, increasing with time until 70-80% are auctioned by 2020, which is a significant departure from 4-5% auctioning on average during Phase II (mainly by Germany and the U.K.). Rules for auctioning are to be adopted by June 30, 2010. Allowances are to be auctioned by Member States, with national shares largely reflecting Phase I emissions.¹² As opposed to granting free allocation under grandfathering (the major mode of allocation under EU ETS in Phases I and II), auctioning is likely to make the allocation process much more efficient. In addition, because regulated companies will have to pay for allowances in the first place, auctioning will make it less likely that companies will have a strong incentive to sell allocations as a source of corporate finance or receive windfall profits.

Auctioning for Electricity Producers

Full auctioning will start in 2013 for electricity producers, with concessions made to some Member States, taking into account the status of the electricity sector and GDP per capita. These Member States will have the option to start auctioning at least at 30% by 2013 reaching 100% by 2020 for existing power plants (not applicable to new entrants in the sector). ¹³ Auctioning, along with unlimited banking to Phase III, should encourage power utilities to bank excess allowances from Phase II.

Auctioning for Industry and Other Sectors

EU-wide rules for free allocation will be adopted by December 31, 2010, with the intent of harmonizing these rules across Member States.

- For industry not exposed to global competition, auctioning will be phased in gradually, starting with a modest 20% in 2013 and increasing to 70% by 2020 (with a view to finally reaching full auctioning by 2027).

10 For the record, the average cap for Phase II has been set at -6% below 2005 levels.

11 The proposal tabled on full auctioning starting 2013 for sectors able to pass through costs (such as power sector) and gradual auctioning (from 20% in 2013 to 100% in 2020) for those sectors exposed to international competition and thus at risk of carbon leakage.

12 For solidarity purposes, 12% of allowances are to be redistributed across Member States, reflecting differences in GDP per capita (10%) and achievements under the Kyoto Protocol (2%).

13 In addition, should this option be elected, those Member States have to undertake measures to green their electricity sector for an amount to the extent possible equal to market value of free allocation.

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- For those sectors exposed to global competition, the aggregate number of free allowances for this group will be set in proportion to their historical share of emissions during Phase I and will decline annually in proportion to the overall Phase III cap.¹⁴

- “To the extent possible”, free allocation to individual installations in both industry categories (above) will be based on benchmarking to best available technology¹⁵. The intent is that free allocation rewards efficient installations more than less efficient installations in any sector.

The sectors and sub-sectors exposed to global competition (and those that are not), will be determined by December 31, 2009, based on an assessment of projected increases in production costs as a result of carbon regulation and degree of openness. The exposure of installations to international competition will be assessed in depth by June 30, 2010, and additional measures to protect these industries may be proposed, as needed.

Proceeds of Auctioning

Auctioning has the potential, not unnoticed by governments, to raise revenues. Depending on the ultimate level of ambition, the extent of banking from Phase II and prevailing market prices during Phase III, the EU ETS could see an average 1.3 billion EUAs being auctioned each year, potentially raising €25-40 billion annually. The EU package makes provision for at least 50% of the revenues to be used for low-carbon and climate-resilient growth, both within and outside the EU. It is envisaged that part of the revenues from the sale or auction of allowances would support climate action in developing countries; another part would support a program including 12 demonstration plants showcasing carbon capture and storage (CCS) applications.¹⁶

The Politics of Auctioning

As an aside, the discussions on auctioning provide a fascinating glimpse into comparative politics and policymaking in different countries. In the U.S., negotiations on how to allocate and spend the proceeds from auctions of allowances are underway and are thought to be key to passage of the draft legislation. In Australia, all auction revenues under the CPRS are to be spent domestically. The EC and Member States, while indicating how 50% of auction resources will be spent, are silent on how the remaining 50% auction revenues will be treated (at least in part, presumably, to protect trade- exposed and non-exposed industries as designated above).

14 The sectors and sub-sectors exposed to global competition will be determined by 31 December 2009, based on assessment of increase in production costs as a result of carbon regulation and degree of openness. The exposure of installations exposed to international competition will be assessed in depth by June 30, 2010, and additional measures to protect these industries may be proposed, as needed.

15 Allocation will be determined on the basis of emissions of the top 15% most efficient plants in the industry.

16 Up to 300 million allowances from the New Entrants Reserve (NER) are available until 31 December 2015 to support a dozen carbon capture and storage power plants and demonstration projects using innovative renewable energy technologies that are not yet commercially viable.

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A^VIATIONB^{ELOW THE}C^AP,STARTING IN 2012

On July 8, 2008, the European Parliament voted to include emissions from aviation in the EU ETS from all flights taking off and landing in the EU starting in 2012. The result of a compromise between the European Commission, Parliament and Council, this decision came about 18 months after the initial proposal by the Commission and was approved on October 2008 by the EU Council. The scheme could target close to 100 airlines, one-third headquartered outside EU. The EU’s decision may be challenged by airlines originating outside the EU because it seeks to regulate emissions from their fleets.

EU-based aviation emissions currently represent about 3% of EU emissions but they are growing rapidly (they have almost doubled since 1990). Estimated at about 218 MtCO2e on average during 2004-06, they could increase to 340 MtCO2e by 2015 and 400 MtCO2e by 2020 (nearly doubling within 15 years).

Emissions are to be capped at 97% of a 2004-06 baseline in 2012, further declining to 95% from 2013 onward with possible revisions at a later date. Specific Aviation Allowances will be issued, with 85%

handed over for free, with that number possibly decreasing beyond 2012.

CERs and ERUs can be surrendered for compliance up to a 15% limit of emissions (to be reviewed beyond 2012; see below). Estimates for Phase III indicate a potential annual shortfall of 160 MtCO2e per year, with a maximum potential demand for emission reductions at about 60 MtCO2e per year.¹⁷ Policies and measures, such as better air traffic management, could also contribute to reducing emissions from the sector.

Emissions from international transport by air or sea are not regulated under a global climate change agreement and the EU decision in this respect is certainly a first. However, only a global agreement could appropriately address any concerns about the potential impact of such regulation on international competitiveness. Accordingly, the EU has been calling for the inclusion of these GHG sources under an international agreement. Should an international agreement fail to materialize, the EU could also choose to unilaterally regulate maritime transport.

More Room for Offsets

The EU ETS 20-20-20 package results in an increase of 20%, or approximately 300 MtCO₂e, in additional allowed volumes of credits from projects compared to the proposal made in January 2008.

This results in a new estimated maximum demand of about 1,700 MtCO₂e over the entire 2008-20 period.¹⁸ For existing installations, the volume of credits from projects allowed in the ETS Phases II and III combined is the higher of either the volume of CERs and ERUs allowed during Phase II¹⁹ or a specific percentage of Phase II allocation (not less than 11%). There will be new special provisions for installations such as power plants in the UK (which have a smaller provision for offsets and already face auctioning). Using information enclosed in National Allocation Plans for Phase II, this could result in an additional 155 MtCO₂e credits from projects allowed between 2012-2020. For new entrants and new sectors, the volume of CERs and ERUs allowed during Phase III is to be no less than 4.5% of annual verified emissions (1.5% for aviation). This could lead to an additional increase in demand for credits from projects by 80-100 MtCO₂e over Phase III. The exact amount of maximum allowed volumes will be determined through a consultation process (“comitology”) led by the Commission.

17 All background data from

http://www.reutersinteractive.com/Carbon/pages/print/posts/?bid=02de22c9-0867-47a0-a32c-e6eb977a4b50&mode=Full.

18 This number corresponds to an average supplementarity limit of about 6% (or less than half the average supplementarity limit of Phase II alone).

19 The average supplementarity limit for Phase II is at 13.4% of allocation, or about 280 million tCO₂e per year.

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For non-ETS sectors, credits from projects up to a level of 3% of 2005 emissions (one-third of the commitment) may be surrendered, as was proposed in January 2008. In addition, a group of Member States meeting certain conditions²⁰ can use an additional 1% of credits from projects with additional restrictions.²¹ On average, this translates into a maximum demand of 700-800 MtCO₂e between 2013- 20 (or about 90-100 MtCO₂e annually). This is roughly comparable to the most recent estimates of annual demand for Kyoto Mechanisms from EU-15 governments under the burden-sharing agreement.

Banking of CERs from Phase II to Phase III

The adopted text describes rules for banking or carry-over of unused CERs and ERUs issued before 2013, which will be valid for exchange with Phase III allowances until March 31, 2015.

Satisfactory International Agreement

In the event of an international agreement, and consistent with the resulting stricter EU-wide emission reductions, additional credits from projects up to 50% of the incremental reductions could be utilized, implying a further additional demand of 1,200-1,300 MtCO₂e over 2013-2020, for a total of 1,500- 1,600 MtCO₂e (almost 200 MtCO₂e annually over 2013-2020) and a maximum demand of 3,000 MtCO₂e over 2008-2020. Although higher than the January 2008 proposal, the maximum allowable EU demand is significantly below the corresponding number of international offsets allowed in the draft U.S. legislation (1,000 MtCO₂e annually). It is unclear to what extent the EU limits will integrate credits from projects alone (i.e., offsets) or also allow credits from programmatic or sectoral initiatives in developing countries. The biggest uncertainty is what criteria will be used by the Commission to determine if any international agreement reached is “satisfactory” or not. It is also not clear what happens if some agreement is announced in Copenhagen but does not deal comprehensively with all the subjects of relevance to the timely adoption of a more ambitious EU target.

Additional Limits on Credits from Projects

The adopted package regulates type and origin of credits from projects for Phase III. Only credits from project types allowed during Phase II in the EU ETS will be accepted during Phase III, although new potential restrictions to their use may be introduced starting January 2013. Limitations including total bans or discounts could be applied by the Commission to certain project types (perhaps including CERs from HFC projects) and changes to their eligibility could be announced with a lead time of between six months and three years.

LULUCF Remains Sidelined

The EC continues to insist on its intent to exclude CDM credits from land use, land use change and forestry (LULUCF) projects from the EU ETS,²² citing concerns with non-permanence, monitoring and reporting requirements, and potential price impact. In this segment, it is likely to leave the field alone for buyers from the U.S. market, where land-based offsets could be welcomed.

Credits from LDCs Attractive for Post-2012 Compliance

Rules governing the use of credits beyond 2012 make CERs and ERUs issued before 2012 particularly attractive, as nothing except the supplementarity limit would restrict their use. CERs and ERUs issued after 2013 from projects that were registered before 2012 would also likely be a safe bet (except LULUCF and possibly industrial gases). Finally, CERs issued from new projects in LDCs registered after 2012 would also be attractive for post-2012 compliance. All of these would of course still be subject to overall use being below the supplementarity limit.

20 Austria, Finland, Denmark, Italy, Spain, Belgium, Luxembourg, Portugal, Ireland, Slovenia, Cyprus and Sweden

21 Allowed credits can be sourced only in LDCs and Small Island States and are not bankable nor transferable.

22 Member States however can continue to use such credits under the effort sharing decision.

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Part of likely EU Negotiation Strategy

If an international agreement is concluded by December 31, 2009, the Commission notes that additional access to credits could be allowed for “additional types of project credits or other mechanisms created under the international agreement.” However, only credits from countries that have ratified the international agreement will be accepted beyond 2012. This is the first time that the concept of “other mechanisms created under the international agreement” is introduced.

If, however, an international agreement is “not concluded by December 31, 2009” then credits from projects “or other emission reducing activities may be used in accordance with agreements concluded with third countries, specifying levels of use.” The Directive here gives the first indication that bilateral agreements will seek credits not from projects alone, but from more amorphous “emission reducing activities.” The language also suggests that there may be some limits placed on the use of credits from any one country but does not elaborate on this.

Finally, the Directive suggests that “any such agreement may also provide for the use of credits [from projects] where the baseline used is below the level of free allocation.” This language implies that credits might only be issued to activities in developing countries that would reduce emissions beyond a European industry emissions benchmark (rather than a host country emissions benchmark). The biggest unknown, again, is what criteria will be used by the Commission to determine if any international agreement reached is satisfactory. It is also not clear what happens if a framework agreement is announced in Copenhagen, but it does not deal comprehensively with all the subjects relevant to the timely adoption of a more ambitious EU target.

Price Control Mechanisms

Increased price volatility in the carbon market revived the debate on the need for market intervention (section 2.4). The Commission has consistently maintained that a well-designed and properly implemented scheme should not require price intervention. It has, however, included in the final text one provision allowing quantitative intervention in the market, to be triggered in the case of extremely high price levels. If, for more than six consecutive months, the allowance price is more than three times the average price of allowances during the two preceding years on the European market, the Commission will convene a meeting with Member States. If it is found that the price evolution does not correspond to market fundamentals, the Commission may either allow Member States to bring forward the auctioning of a part of the quantity to be auctioned, or allow them to auction up to 25% of the remaining allowances in the New Entrant Reserve.

2.2 THE U.S. IS BACK AT THE TABLE

On May 15, 2009, U.S. Representatives Henry Waxman and Ed Markey formally introduced the Clean Energy and Security Act (HR 2454), a legislative proposal to establish a national renewable energy standard and an economy-wide cap and trade program. The proposal underwent a spirited debate and several revisions in the House Committee on Energy and Commerce and the Sub- committee of Energy and Environment, before reaching the full House of Representatives. The bill, which is referred to in this report as the Waxman-Markey Draft Bill (“W-M” or “Draft” or “bill”) is expected to come for a vote before the full House of Representatives by the time this report is published. There are changes expected to specific language during the mark-up and the reader is cautioned to use the information that follows as indicative only.

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LIKELY IMPACTS OF FEDERAL REGULATION ON EXISTING AND UPCOMING

STATE-BASED AND REGIONAL INITIATIVES

A number of state-based and regional initiatives have emerged in North America over the past few years, with the goals of implementing emissions trading programs and influencing any federal scheme. The future of these schemes – and interest in carbon instruments issued by them – will largely depend on their treatment in upcoming legislation at the Federal level.

RGGIMARKET

Market activity in the Regional Greenhouse Gas Initiative (RGGI) gathered steam in 2008 in preparation for the official 2009 start of operations, and interest has grown significantly during the first half of this year.²³ Prices of RGGI Allowances (RGGA) is now reported around US$3.90 per short tCO2e (€3 per short tCO2e) in a market that is likely to be long emissions in its first years. Analysts consider that likely fungibility of RGGI Allowances into the federal system,²⁴ along with the possibility of banking to later RGGI phases, has possibly helped keep price above the US$1.86 auction reserve price.

CHICAGO CLIMATE EXCHANGE (CCX)

Members of the Chicago Climate Exchange (CCX) had made voluntary, but firm commitments to reduce GHG emissions by 6% below a baseline period of 1998-2001 by 2010. CCX continued to see record- breaking activity in 2008, tripling transacted volumes at 69 MtCO2e for a value of US$309 million (€211 million), more than quadrupling 2007 values. America’s Climate Security Act, sponsored by Senators Lieberman and Warner,²⁵ was introduced in October 2007 and reported by Committee in December 2008 before a cloture vote blocked further debate on the bill. The sharp rise in 2008 values is related to particularly high prices in the first part of the year, following a perception that passage of the bill would result in favorable treatment. The Chicago Climate Exchange Carbon Financial Instrument (CCX-CFI) skirted above US$7.00 per tCO2e in early May 2008 before plunging to less than US$2 by mid-September, when it became clear that the Lieberman-Warner bill would not become law. The CCX- CFI is currently trading in the US$1-2 price band, as the market perceives that a U.S. federal market is unlikely to recognize the value of CCX-CFIs.²⁶

CÂLIFORNIAG^LOBALWÂRMINGSÔLUTIONSA^CT

The passage of Assembly Bill 32 (California Global Warming Solution Act AB32) in August 2006 sets economy-wide GHG emissions targets as follows: Bring down emissions to 1990 levels by 2020 (considered to be at least a 25% reduction below business-as-usual) and to 80% of 1990 levels by 2050.

Covering about 85% of GHG emissions, a cap and trade scheme (still under design) would be a major instrument, along with renewable energy standards, energy efficiency standards for buildings and appliances as well as vehicle emissions standards. Allowances issued by California and other states before 2012 could also be exchanged for Federal carbon allowances under the proposed W-M draft legislation.

CALIFORNIA CLIMATE ACTION RESERVE

The prospect of fungibility with federal law, among other reasons, has stimulated a domestic offset market, through the California Climate Action Registry (now known as the Climate Action Reserve).

This new market generates Climate Reserve Ton (CRT) units, which currently comprise project types from livestock and landfills across the U.S. and forestry project offsets in California. Early transactions for one to 10 year terms forward have been reported with prices ranging between US$5.00 and US$14.00 depending on the location, project type and volume of supply guaranteed in contracts. The primary buyers of these CRTs have been pre-compliance buyers with an eye to California’s law AB32, the emerging Western Climate Initiative (WCI), and a potential Federal U.S. program.

23 See Report on the Secondary Market for RGGI CO2 Allowances, May 2009.

http://rggi.org/docs/Secondary_Market_Report_May_2009.pdf

24 The W-M Draft provides for “compensation” for held allowances equal to a weighted average price based on the auction clearing price for that vintage year.

25 See State and Trends of the Carbon Market 2008.

26 Additionally, pure voluntary buyers appeared to favor VCS and Climate Action Reserve CRTs to meet their needs as these two latter standards are project specific as opposed to purchasing generic CFI’s directly off of the CCX.

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W^ESTERNC^LIMATEI^NITIATIVE

The WCI covers a group of seven U.S. states (Arizona, California, Montana, New Mexico, Oregon, Utah and Washington) and four Canadian provinces (British Columbia, Manitoba, Ontario and Quebec), with an aggregate emissions target of 15% below 2005 levels by 2020. Other U.S. and Mexican states and Canadian provinces have joined as observers. Cap and trade would here again be a major instrument, and transition modalities to a federal cap and trade scheme are now considered under the W-M draft bill.

2.2.1 Energy, Climate…and Trade/Competitiveness

The W-M Draft Bill has four major sections, referred to as Titles. In addition to the cap-and-trade provisions contained in Title III, the Draft contains provisions for a range of policies and measures such as a federal Renewable Electricity Standard (RES); a higher emissions standard for new coal- fired power plants and a program and fund for CCS deployment; a fund to manage federal financial assistance to states related to clean energy, e.g., for weatherization assistance, and encouragement for deployment of a smart grid; and authorization for federal agencies to sign long-term (up to 30 year) contracts for the purchase of renewable energy. There are also related initiatives included in programs on energy efficiency (in buildings, lighting, appliances); for industry; transportation systems;

electricity and gas distribution systems; smart grids) and transition to a clean energy economy (including CCS). There are also provisions that seek to protect trade sensitive sectors from international competition and provisions to help states transition toward a cleaner investment future.

TITLE I:CLEAN ENERGY

The Draft’s Renewable Electricity Standard requires that the share of renewable energy sold by electric utilities²⁷ is to rise from 6% in 2012 and to 15% by 2020. This is part of a combined program with an energy efficiency resource standard (5%), for a combined target of 20% by 2020. Some applications (e.g., electricity generation from distributed energy resources, such as solar photovoltaic, will receive triple credit under the program. RES provides for compliance flexibility in that it allows utilities to meet their obligations by buying, selling and trading federal Renewable Energy Certificates (RECs). The Draft also allows individual state-level renewable portfolio standards to co-exist along with the federal program.

TITLE II:ENERGY EFFICIENCY

The bill calls for a 30% improvement of model energy codes for new commercial buildings (ASHRAE) and homes (IECC) and 50% improvement after 2016. It allows states to implement nationally-consistent energy retrofit programs for residential and commercial buildings. Both programs would be performance- based, i.e., greater energy savings would gain larger monetary rewards. A rebate program is also proposed in order to purchase and destroy manufactured housing built before 1976 and replace it with Energy Star manufactured homes.

The bill sets efficiency standards for outdoor lighting and portable light fixtures, and for water dispensers, hot food cabinets, and spas. “Cash for clunkers”-type payments have been proposed for the early retirement of household appliances such as refrigerators and washing machines and “golden carrot”-type incentives proposed for best-in-class, highly-efficient appliances. There are also efforts to change the long-term direction of transportation planning; to increase requirements for gas and electric utilities to produce energy savings, including both demand- and supply-side efficiencies; and provide grants for innovative energy savings in industrial motors and through changes in process engineering.

27 The RES mandate would apply to larger utilities (those selling at least 1 million megawatt-hours of electricity annually).

State and Trends of the Carbon Market 2009

The World Bank

State and Trends of the Carbon Market 2009

Washington, D.C. [ May 2009

S TATE AND T RENDS OF

THE C ARBON M ARKET 2009

Karan Capoor

Sustainable Development Operations, World Bank

Philippe Ambrosi

Climate Change Team, World Bank

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W

TABLE OF CONTENTS

I E

S

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II ALLOWANCE-BASED MARKETS

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S ^{TATE AND} T ^{RENDS OF}

THE C ^ARBON M ^ARKET 2009